Professional Documents
Culture Documents
RESERVE SYSTEM
BY
With a Preface by
BENJAMIN STRONG, LL.D.
GOVERNOR OF THE FEDERAL RESERVE BANK OF NEW YORK
FIFTH EDITION
1922
C H A P T E R I
PURPOSE A N D P L A N * 1-2
Lack of familiarity with federal reserve system on part
of public, and its dangers, 1.—Purpose of book, 2.—
Plan of book, 2.
C H A P T E R II
DECENTRALIZATION OF A M E R I C A N B A N K I N G PRIOR TO FEDERAL
RESERVE S T STEM 3-7
Banks lacked organization and effective leadership in
time of crisis, 3-4.-—Reserves widely scattered, 4-6.—Re-
serves immobile, 7.
C H A P T E R III
INELASTICITY OF A M E R I C A N BANK CREDIT PRIOR TO FEDERAL
RESERVE SYSTEM £-18
Extent to which bank credit is used as a medium of
exchange, 8-10.—Why circulating bank credit should be
elastic, 10-ll.^Bank-note inelasticity over long periods
under old banking system, 11-13.—^Seasonal inelasticity
of bank notes, 13-15.—Bank-note inelasticity in times of
crisis, 15-17,—Inelasticity of deposit credit, 17.—Evil re-
sults of credit inelasticity, 18.
C H A P T E R IV
DEFECTIVE E X C H A N G E A N D TRANSFER SYSTEM 19-24
The "float** and the practice of routing checks, 19-21.—
Checks in transit commonly counted as legal reserve
money, 21-22.—Large domestic shipments of currency re-
quired under old banking regime, 22-23.—Foreign exchange
difficulties, 2 3 - 2 4 .
C H A P T E R V
DEFECTIVE B A N K I N G M A C H I N E R Y FOR FEDERAL G O V E R N M E N T . . 25-27
Difficulty of apportioning government funds among nine
sub-treasuries and over fifteeen hundred depositary banks,
2 5 - 2 6 . — F o u r evil results o f p r a c t i c e , 2 6 - 2 7 . — S u m m a r y o f
defects of old banking system, 27.
C H A P T E R VI
How THE FEDERAL RESERVE SYSTEM IS REMEDYING T H E OLD
E V I L OF THE DECENTRALIZATION OF AMERICAN B A N K I N G . . 28-50
Division of country into twelve federal reserve dis-
tricts, 28-29.—Membership in federal reserve system.
29-31,—Democracy of federal reserve banks* plan of or-
ganization, 31-34.—Coordination of twelve federal reserve
banks and centralization of their control provided for by
means of federal reserve board, advisory council, and class
C directors of federal reserve banks, 34-36.™District cen-
tralization of bank reserves, 36-39.—Mobilization of re-
serves, 30-40.—Inter-district mobility of reserves, '40.—
Rediscounting by one federal reserve bank for another,
'40-43.—Open-market operations, 43-45.—Creation of a
broader discount market for commercial paper, 4 5 - 4 6 . —
Increasing use of the trade acceptance, and advantages of
trade acceptance over open-book account credit, 4 6 - 4 1 . —
The bank acceptance, 47-49.—Inter-district mobility of
reserves promoted by increasing use of trade acceptances
and bank acceptances, 48-49.—Intra-district mobility of
reserves increased by federal reserve system, 4 9 - 5 0 .
CHAPTER VII
CREDIT ELASTICITY UNDER T H E FEDERAL RESERVE SYSTEM 51-66
Provisions of federal reserve act for bond-secured
national bank notes, 51-52.—The federal reserve bank
note, 52.—Federal reserve notes, 52-53.—Their elasticity,
53-58,—Elasticity of deposit currency obtained in a num-
ber of ways: Removal of old rigid legal reserve require-
ments, 58. New legal reserve requirements less rigid
and may be suspended in times of emergency, 59-63.
Privilege of rediscounting at federal reserve banks, 63-
64. Privilege of borrowing on collateral notes with short
maturities, 64.—Contractility of circulating credit under
federal reserve system, 6 5 - 6 6 .
C H A P T E R VIII
DOMESTIC AND FOREIGN E X C H A N G E UNDER T H E FEDERAL RE-
SERVE SYSTEM 67-84
Provisions of federal reserve law concerning domestic
exchange, 67-70.—Early experiments of the federal reserve
authorities as regards the clearing and collection of
checks, 70. Present clearning and collection system,
71-76.—The gold settlement fund, 76-79.—Foreign ex-
change, foreign agencies and branches of American banki
organized for foreign business under the new banking
system, 8 0 - 8 4 .
C H A P T E R I X
T H E FEDERAL RESERVE S Y S T E M A X D T H E FEDERAL T R E A S U R Y . . 85-98
Federal reserve banks authorized by law to be deposi-
taries of government funds, 85-86.—Extensively used as
depositaries by Secretary of the Treasury, 85-88.—Fed-
eral reserve banks as fiscal agents of Government render
invaluable services in the financing of the war, 89.
By
BENJAMIN STBONG, L L J X
Governor of the Federal Reserve Bank of New
York
CHAPTER I
Reserves Scattered
The most serious feature of this decentraliza-
tion was the scattering of reserves. Thirty thou-
sand different banks meant 30,000 cash reserves,
and these reserves for the commercial banks were
more than the mere "till money" which the "cash
balances" of most foreign banks represent. They
were actual reserves, substantial in amount, upon
which the banks placed their prime dependence
for times of emergency. It is true that most
banks had so called ^deposited reserves," name-
ly, funds on deposit in other banks, which they
were allowed to count as part of their "legal
reserves"; and they had so called "secondary re-
serves," namely, funds invested in securities and
call loans, which were supposed to be quick assets
that could be liquidated at once in time of need.
Strictly speaking, however, neither of these "re-
serves" was a reserve at all. The deposited re-
serve was after all merely a deposit in another
bank, which the depository bank loaned out—
commonly at call on the stock exchange—and
Reserves Immobile
Obviously a country's reserve money must to
a large extent be concentrated in one reserve or,
at most, in a few large reserves, if it is to be ef-
fective. It must be marshalled in armies, not
scattered in small squads. But these armies must
be mobile so that they can be quickly moved
singly or in combinations to places of threatened
attack. An army's mobility is a big factor in its
efficiency—a truth which the great mobility of
the armies of the Central Powers in the recent
war has emphasized. Our American bank re-
serves were not only scattered, they were also im-
mobile. There was no effective way of quickly
gathering them together and massing them at the
points of financial danger.
These then were the three most serious phases
of our banking decentralization: (1) Absence of
a responsible national conservator of our money
market, like the Bank of France or the Bank of
England. (2) Scattered bank reserves. (8)
Immobile bank reserves.
Bank-Note Inelasticity
Our national bank notes, which should have
furnished the elastic element in the country's
hand to hand money, were notoriously inelastic.
National banks were authorized to issue these
notes by depositing with the Government United
States bonds equal in par value to the notes is-
sued.1 The banks were supposed to realize a
"double profit" on the bank notes, namely, in-
terest on the bonds, and interest on the notes
when they were loaned out as money. After 1900
the bonds used, however, were mostly two per
cent bonds of 1930, and as the issue of bank notes
i If the market value were below the par value* additional
bonds were to be deposited so as to make the market value at
least equal to the notes issued. In recent years the market value
of these bonds has been usually above the par value.
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Federal Reserve Bank of St. Louis
FEDERAL RESERVE SYSTEM 11
circulation showed up very unfavorably in com-
parison with the bank-note circulation of Canada,
which, under the system of branch banks and an
asset bank-note currency, was highly responsive
to seasonal variations in currency needs. The
contrast will be made clear by the following chart
(Chart II) showing the variations in the monthly
bank-note circulation of the two countries prior
to November, 1914, the date when the federal
reserve banks were opened,4
In times of crisis national bank notes could not
be depended upon to provide additional currency.
Government bonds were usually difficult to se-
cure on favorable terms at such times, and the
machinery for taking out new circulation worked
too slowly. Some progress was made in the di-
rection of improving the old system in this regard
during the latter years of the old regime; and,
under the spur of strong appeals to the banks and
active assistance from the Treasury Department,
there was some helpful increase in the national
bank-note circulation at the times of the panic of
1907 and the crisis of 1914. A t best, however,
* The figures plotted on the chart do not include the circula-
tion of the so-called Aldrich-Vreeland emergency notes, which were
first issued in August, 191'4, reached their maximum in October,
and were all retired by the following July. Legal authority to
issue such emergency notes expired by limitation June 30, 1915.
Federal Reserve Act, section 37.
Domestic Exchange
Of the hundreds of billions of dollars in checks
drawn every year, a very large proportion are
for local payments, and, being settled promptly
through local clearing houses or directly between
the banks concerned, offer no difficulties. Our
American clearing house machinery is a marvel
of perfection for the settlement of local checks.
In addition to the checks drawn for purely local
19
Plan of Organization
All national banks are required to be members
of the system, and state banks and trust com-
panies (which conform to certain standards as
to size and character of business) are encouraged
to join. Comparatively few state institutions
joined during the first two years of the system,
but the liberal policies of the federal reserve
iThe map is a reproduction of the one published in the
Federal Reserve Bulletin of November, 1931.
Mobilization of Reserves
A corollary to the district centralization of re-
serves is their mobilization. Reserve money must
not only be piped into a few large reservoirs, but
these large reservoirs must be piped together, and
there must be a pumping engine of sufficient
power to force the reserves promptly and in large
quantities to any place desired. The federal re-
« See pages 59-61.
Inter-District Mobility
Broadly speaking there are three ways in which
the federal reserve law has increased the inter-
district mobility of reserve money. They are:
(1) Rediscounting by one federal reserve bank
for another. (2) Open market operations of fed-
eral reserve banks. (3) Creation of a broader
discount market for commercial paper.
Rediscounting by one Federal Reserve Bank for
Another
Under the old banking system, as we have seen,
in time of emergency, each bank held tight its
own reserves, or, to change the figure, "sat firmly
Open-Market Operations
While the federal reserve banks are essentially
bankers' banks, since their stock is owned ex-
clusively by member banks and since their only
regular domestic customers are banks and the
federal government, it is none the less true that
Congress found it necessary to confer upon these
banks certain limited rights of dealing with the
outside public. The possession of such rights by
the federal reserve banks appeared necessary,
first, as part of the machinery for conserving the
American money market and making their dis-
count rates effective7 and second, as a method of
7 If, for example, a federal reserve bank raises its discount
rate in order to prevent dangerous loan expansion on the part of
member banks or to prevent an undue outflow of gold from the
country, it may happen that the member banks may not be con-
vinced of the need of such precautionary measures, and, not be-
ing in need of securing funds from the federal reserve bank by
way of rediscount, may ignore the efforts of the federal reserve
bank to conserve the money market The banks may accordingly
continue the policy of loan expansion at low discount rates.
Under such circumstances the federal reserve rate would be said
to be "ineffective." To meet this situation and force the banks
"into line" the federal reserve bank may go into the open market
and sell bank acceptances, commercial bills, municipal warrants
2 Pages 56-57.
Total $3027
The figures show therefore that 67 per cent of the
federal reserve notes outstanding, or 75 per cent
of the notes in actual circulation, were backed
dollar for dollar by gold as collateral.
Eor the purpose of contracting the circulation
of federal reserve notes when the business de-
mands for currency decline, the machinery is as
follows. When the demand for notes in the
pockets of the people and the tills of merchants
falls off, as it does, say, after the harvesting sea-
son in the autumn, the surplus notes are deposited
by the public in the banks. Inasmuch as national
banks cannot count these notes in their vaults as
legal reserve money, they will tend to send to
their federal reserve banks for deposit any notes
they receive in excess of the amount needed for
till money. Transportation charges on such
®The law (as amended March S, 1919) provides that after the
6 per cent cumulative dividend claims have been met, the net
earnings of each bank shall be paid to the United States as a
franchise tax; except that the whole of such net earnings shall
be paid into a surplus fund until the surplus Bhall amount to 100
per cent of the subscribed capital stock. After this 100 per cent
Rediscount
Federal reserve banks always stand ready to
rediscount in time of need eligible paper for mem-
ber banks.
For the purpose of keeping the assets of fed-
eral reserve banks liquid, the law and the ad-
ministrative regulations of the federal reserve
authorities place rigid limitations upon the kinds
of paper eligible for rediscount. These limita-
tions have reference both to the length of time
the paper is to rim, and to the purpose for which
it is issued. As to time, notes rediscounted must
have a maturity at the time of rediscount of not
more than 90 days (exclusive of days of grace);
except that a limited amount of bills drawn for
agricultural purposes or based on live stock may
be rediscounted, provided they have a maturity
not exceeding six months (exclusive of days of
grace). As to the purpose for which the bills are
Collateral Loans
The second type of loan is the discount of col-
lateral notes of member banks. These notes must
be for periods not exceeding fifteen days, and the
only permissible collateral is "such notes, drafts,
bills of exchange, or bankers' acceptances as are
eligible for rediscount or for purchase by federal
reserve banks," and bonds or notes of the United
States Government. There was no provision in
the original act for collateral loans, but experi-
Domestic Exchange
Under the old regime the collection and clear-
ing of out-of-town checks for country banks was
handled largely by the banks in reserve and cen-
tral reserve cities, which were the depositories of
the legal reserves of the country banks. The ser-
vice of collecting these out-of-town checks was
rendered to the country bank as a partial com-
pensation for the use of its reserve deposits at a
low rate of interest, and as a lure to secure other
business from the country bank, competition hav-
ing been keen among large banks in money mar-
ket centers for the accounts of out-of-town banks.
When Congress decided, therefore, that the sys-
67
Resources
Gold coin and certificates in vault1 $488,917,000
Gold settlement fund—federal reserve
board2 465,236,000
Gold with foreign agencies8
Liabilities
Capital paid-in10 103,104,000
Surplus17 213,824,000
Reserved for govt, franchise taxls 55,119,000
Deposits:
Government10 45,913,000
Member banks—reserve account20 1,670,362,000
All other21 26,555,000
Total 1,742,830,000
Deferred availability items22 162,795,000
Federal reserve notes in actual circulation23 2.366,006,000
Federal reserve bank notes in actual circu-
lation—net liability24 75,862,000
All other liabilities25 24,856,000
branch offices
Sec. 3.1 The Federal Reserve Board may
permit or require any Federal reserve bank to
establish branch banks within the Federal re-
serve district in which it is located or within the
district of any Federal reserve bank which may
have been suspended. Such branches, subject
to such rules and regulations as the Federal Re-
serve Board may prescribe, shall be operated
under the supervision of a board of directors to
consist of not more than seven nor less than
three directors, of whom a majority of one shall
be appointed by the Federal reserve bank of the
district, and the remaining directors by the Fed-
eral Reserve Board. Directors of branch banks
shall hold office during the pleasure of the Fed-
eral Reserve Board.
1 As amended by act approved June 21, 1917 (40
Stat., chap. 32).
OPEN-MARKET OPERATIONS
NOTE ISSUES
refunding bonds
bank examinations
foreign branches
Sec. 25. 1 Any national banking association
possessing a capital and surplus of $1,000,000
or more may file application with the Federal
Reserve Board for permission to exercise, upon
such conditions and under such regulations as
may be prescribed by the said board, either or
both of the following powers:
First. To establish branches in foreign coun-
tries or dependencies or insular possessions of
the United States for the furtherance of the
foreign commerce of the United States, and to
*As amended by act approved Sept 7, 1916 (30
Stat., 752, chap. '461), and act approved Sept 17,1919.
government depositaries
Sec. 6. That all Federal land banks and
joint stock land banks organized under this
188
Foreign branches:
Accounts kept separate
Agreement to comply with regulations of Federal Re-
serve Board
Application to establish *5
Establishment *5
Failure to comply with regulations »
6
Secretary of Treasury:
Deposits with, by Federal Reserve Bank or agent 16
Ex officio member of Federal Reserve Board 10
Expenses of handling deposits 16
Gold reserve to be maintained by 26
Management of United States stock.... 2
Shareholders (see also Stock), individual liability:
Federal Reserve Banks 2
National banks 23
Silver certificates, substitution of federal reserve bank notes
for, tee "Pittman Act," Appendic E.
State banks:
Cancellation of stock in Federal Reserve Bank 9
Certificates as to liabilities of debtors 9
Certifying checks against insufficient funds 9
Conditions of membership 9
Converted into national banks 8
Depositories of government funds, see Appendix D.
Eligibility for membership 9
Examination. (See "Examinations") 9
Examinations, not subject to requirements of section 21 9
Forfeiture of membership 9
May become members of Federal Reserve Bank 9
Must be eligible for conversion into national banks... 9
Penalties for failure to make reports 9
Qualifications required to become members 9
Regulations ®
Retain powers under State charters 9
State examinations may be accepted 9, 21
Subject to provisions and penalties of Revised Statutes
5209, upon becoming members 9
Subject to section of Federal Reserve Act applied to
member banks; but not subject to section 31 9
T
Tax upon delinquencies in reserves 11-c
Time deposits, definition 19
Trust companies, acceptance of terms of Federal Reserve
Act 9
Trust powers of national banks. 11-k
U
United States stock:
Allotment by organization committee 9
Management by Secretary of the Treasury 9